Congress originally enacted the alternative minimum tax (AMT) to make sure that high-income folks would pay at least a minimum amount of income tax. Sound familiar? It seems awfully similar the “Buffett rule,” the principle that those with incomes above $1 million should pay at least 30 percent of their income in taxes.
As currently constructed, the AMT adds enormous complexity to the tax code and increasingly burdens middle-class families. So it seems natural to ask: why not just replace the AMT with a version of the Buffett rule?
To help answer that question, the Tax Policy Center estimated what it would cost to scrap the AMT and enact the Fair Share Tax, a recent legislative proposal that would impose a 30 percent minimum tax on individuals earning more than $1 million. (The tax would phase in so its full force wouldn’t hit taxpayers as soon as their income topped $1 million.)
We found that the Fair Share version of the Buffett rule wouldn’t come close to paying for AMT repeal. Scrapping the AMT would lose a whopping $1.2 trillion relative to current law between now and 2022. The Fair Share Tax would only recover about $100 billion of that revenue, for a net loss of $1.1 trillion.
What would it mean relative to current policy – a more realistic baseline under which the AMT would be permanently patched and the 2001/2003/2010 tax rates extended? The AMT fix would reduce revenue by $550 billion over the decade while lower rates would boost the amount the Fair Share tax would bring in by about $150 billion. The net: the swap would still lose $400 billion over 10 years.
Why does the AMT generate so much more revenue than the Fair Share tax? The biggest reason is that the AMT simply hits a much bigger chunk of taxpayers. By design, the Fair Share tax wouldn’t affect anyone making less than $1 million. Yet 96 percent of AMT taxpayers have incomes under $1 million, accounting for 77 percent of all AMT revenue. The Fair Share tax would need to start at a much lower income level to make up the lost revenue from the AMT.
The AMT may be a mess, but it would be awfully costly to replace.
In the face of growing income inequality and big budget deficits, some political leaders and commentators are showing a growing interest in raising taxes on the rich. But the ideas on the table would have very different results.
The Tax Policy Center has looked at several plans, including the 28 percent limit on the tax savings from itemized deductions that President Obama has proposed and a minimum 30 percent tax rate on households earning over $1 million. Obama has endorsed this “Buffett rule,” although he has not proposed a specific version. TPC also analyzed a 21 percent effective minimum tax that would phase in for couples with income over $250,000 ($200,000 for singles). This EMT is similar to the Buffett rule, but would apply a lower minimum tax rate beginning at a lower income level. Both the Buffett rule and the EMT would be imposed on top of the current alternative minimum tax.
Relative to TPC’s current policy baseline, which assumes the 2001-2010 tax cuts and the AMT patch are extended, the version of the Buffett rule proposed by Sen. Sheldon Whitehouse (D-RI) and Rep. Tammy Baldwin (D-WI) would raise taxes on about 185,000 households by an average of $215,000 in 2013. The EMT would hit about twice as many households but raise their taxes by less than half as much on average.
Overall, the limit on itemized deductions would reduce after-tax income by an average of 0.2%, the EMT by 0.3%, and the Buffett rule by 0.5%. But as the chart shows, the three plans would affect different taxpayers in very different ways. The 28 percent cap would start to bite for the highest-income 10 percent of households and would grow modestly with incomes. The EMT would hit only the top 5 percent but would increase taxes much more at the very top, reducing after-tax income by 2.4% for the top 0.1 percent. The Buffett tax wouldn’t hit anyone outside the top 1 percent but would strike those high-income households with a vengeance, slashing after-tax incomes for the top 0.1 percent by an average of 5.4%.
The big reason why the Buffett rule would hammer the highest-income households is that it would dramatically raise their effective marginal rates on capital gains. That would encourage them to delay taking profits to avoid those higher rates. Some might even spread realizations over multiple years or not realize some gains at all. The result: a much reduced revenue pickup.
This change in behavior is also a problem for economic efficiency. When investors change the timing of their asset transactions to reduce their taxes, they are no longer allocating their capital in the best possible way. But the narrowing of the differential between capital gains and ordinary income also has the beneficial effect of reducing incentives to convert ordinary income to capital gain.
The 21 percent EMT rate would produce much less distortion in the decision to realize capital gains than the Buffett rule’s 30 percent rate, but would still retain a substantial capital gains/ordinary income differential. And the 28 percent limitation on itemized deductions would distort behavior the least (and would reduce some existing distortions) since it would effectively broaden the tax base rather than increasing marginal rates.
None of these piecemeal approaches is as good as broad tax reform. But in the meantime, it’s worth remembering that all taxes on the rich are not created equal.
The Paying a Fair Share Act of 2012 (PFSA) – Congress’ first crack at legislating the Buffett rule – would apply a broad-based 30 percent minimum tax for those earning more than $1 million a year. We have a pretty good idea of how this would affect people’s taxes: it would substantially raise them but only for relatively few high-income taxpayers.
Of course, economists don’t just want to know the total tax burden; we also care about incentives. So we looked at how PFSA would affect the amount of tax people pay on their next dollar of income – that is, their effective marginal tax rates.
We care about marginal rates because they measure the tax disincentive for earning additional income. High effective marginal rates on wages may discourage work effort, and high effective marginal rates on capital gains may distort investment decisions and discourage realizations of capital gains. Beyond generating efficiency loss, these reductions in realizations would mitigate the revenue pickup from raising capital gains rates.
Since effective marginal rates depend on all taxes applied to work effort and capital gains and include the effects of tax preferences, the statutory rate brackets in the income tax are only part of the story. Wages face an additional 7.65 percent payroll tax on both the employee and employer, so payroll taxes contribute an extra 14.2 percentage points to the marginal tax rate on pretax earnings (15.3 divided by 107.65, the gross wage including the employer tax). However, earnings above the Social Security wage threshold face only the Medicare Hospital Insurance (HI) tax, which is 1.45 percent on both employees and employers, for a total rate of 2.86 percent (2.9/101.45). And earnings above $125,000 (or $250,000 for joint filers) get hit with an additional 0.9% surtax starting in 2013.
Meanwhile, capital gains and qualified dividends face a top rate of only 15 percent – plus an additional 3.8 percent on net investment income for high earners beginning in 2013, courtesy of health reform. Various phase-ins and phase-outs in the tax code complicate things further; for example, taxpayers in the AMT exemption phase-out range face effective marginal rates several percentage points higher than their statutory rates on both earnings and capital gains.
How would PFSA affect all of this? TPC estimates that the proposal would increase average effective marginal rates for high-income taxpayers – but not for all types of income. Effective marginal tax rates on capital gains would nearly double from 18 percent (under current policy) to 34 percent for taxpayers with incomes between $1 million and $2 million, and would climb to 29 percent for taxpayers with incomes over $2 million. That jump shouldn’t come as a surprise. As Warren Buffett has been telling us, high-income taxpayers who face low tax rates tend to have lots of capital gains, which are currently taxed far below the fair share tax rate of 30 percent. (If you’re wondering, taxpayers with incomes between $1 million and $2 million face a higher effective marginal rate than taxpayers with incomes over $2 million because the fair share tax phases in over that range.) Capital gains realizations would fall dramatically in response to these high marginal rates, which – according to some estimates – would actually exceed the revenue-maximizing tax rate on capital gains.
The average effective marginal rate on wages actually decreases slightly for those with very high incomes. While this seems counterintuitive, it actually makes sense. Between income and payroll taxes, most high-income taxpayers already face a marginal rate above 30 percent on their wages. If they end up on PFSA – most likely because their capital gains pull their average tax rate down below 30 percent – their 30 percent marginal rate on earnings will actually be less than they were paying before.
Yes, raising taxes on a couple hundred thousand of the highest-income Americans sounds awfully appealing. But narrowly based tax increases often come at an efficiency cost. And in this case, the most likely source of efficiency loss comes from discouraging realizations of capital gains.
By Dan Baneman and Jim Nunns
With election season heating up and 2012 just around the corner, we are hearing a lot about the pending expiration of the Bush-era tax cuts. If the debate over the original 2010 expiration is any guide, much will center on whether the top rate should increase from 35 percent to the pre-2001 level of 39.6 percent. While these rates will be characterized as being very high, in historical terms they’re actually quite low. Between 1954 and 1963, for example, there were 24 tax brackets (compared to 6 today), and 19 of them were higher than 35 percent. The top rate? A whopping 91 percent.
Massive federal deficits and rising income inequality make it worth asking: just how important were those higher rates in raising revenue? To answer to that question, we compiled IRS data on the amount of tax generated at each statutory marginal tax rate, dating back to 1958.
This is what we found: Those high rates really did raise revenue. Although only a small fraction of tax returns were affected by very high rates, the taxes paid at those rates accounted for a substantial portion of individual income taxes paid. Between 1958 and 1986, an average of 14% of individual income tax revenues were generated at rates above 39.6 percent, and an average of 6% of revenues were generated at rates above 50 percent. At their peak in 1986, rates above 39.6 percent accounted for an impressive 23% of income tax revenue.
We did a bit of quick math to see how much revenue could be raised by boosting income tax rates. Between 1958 and 1981 (the last year with rates above 50 percent), the average effective tax rate on brackets above 35 percent was 49 percent. That is to say, the total tax paid in those brackets came out to 49 percent of the taxable income in those brackets, compared to 35 percent under the current rate structure.
In 2007, if taxable income in the 35 percent bracket had been taxed at 49 percent, federal income tax revenues would have been $78 billion higher (taking into account likely behavioral responses). That won’t solve the deficit problem, but it’s hardly chump change: an extra $78 billion would have increased 2007 income tax revenues by nearly 7%.
Restoring pre-1982 effective rates wouldn’t require implementing pre-1982 statutory rates. Raising the top statutory rates is one way to increase effective rates, but it’s not the only (or best) way. For instance, more modest rate increases could be supplemented by scaling back tax preferences that disproportionately benefit high-income taxpayers (like the mortgage interest deduction) and very high-income taxpayers (like the preferential rate on capital gains).
It’s clear that we can’t solve the deficit problem just by increasing taxes at the top. Unless we are willing to make massive cuts in retirement and health benefits that many American families rely on, our revenue needs will be too great to avoid broader tax increases. And higher taxes should come from a reformed – fairer, simpler and more efficient – tax system. But it may not be unreasonable to ask taxpayers at the very top of the income distribution, who have received most of the income gains over the past 30 years, to pay income taxes at levels comparable to those paid prior to the 1980s.